Thursday, January 18, 2018

Canada's Hyper-Leveraged Economy?

The unprecedented rise in consumer debt means the Bank of Canada’s rate-hiking cycle is already the most severe in 20 years and further increases will have far graver consequences than conventional analysis shows, Macquarie Capital Markets Canada Ltd. said.

Assuming just one further rate rise, the impact would be 65 percent to 80 percent as severe as the 1987 to 1990 cycle, according to Macquarie, which took into account five-year bond yields, household debt and home buying. Canada’s housing market slumped in the early 1990s after that rate-hike cycle and a recession.

“The Canadian economy has experienced an unprecedented period of hyper-leveraging,” analysts including David Doyle wrote in the note released Thursday. According to Macquarie, this is underlined by the fact that:

About 30 percent of nominal GDP growth has come from residential investment and auto sales over the past three years. This is about 50 percent greater than what has been experienced in similar prior periods.

The wealth effect from rising home prices has driven nearly 40 percent of nominal growth in gross domestic product over the past three years, about two to four times the amount experienced previously when the BoC was hiking rates.

Even as this has occurred, fixed business investment and exports have struggled, limiting the ability for a virtuous domestic growth cycle to unfold. This again is in sharp contrast to similar periods in the past when these were accelerating.

New mortgage stress-test rules will also have a larger impact than estimated, Macquarie said. The new rules in isolation are expected to reduce buyers’ maximum purchasing power by as much as 17 percent. That jumps to about 23 percent after incorporating the rise in mortgage rates since mid-2017, according to the note.

Governor Stephen Poloz has indicated high household debt could make the slowing impact of rate hikes harsher, and that the impact of 2017’s increases will not be fully clear for 18 months, Doyle said.

“When taken together, these observations mean the Bank of Canada is proceeding with hikes despite uncertainty surrounding the severity of tightening performed so far,” Macquarie writes. “This elevates the risk of policy error.”

Macquarie expects only one more rate hike in either April or July.

On Wednesday, the Bank of Canada increased its target for the overnight rate by 25 basis points (0.25%) to 1 1/4 per cent. The Bank issued this press release (added emphasis is mine):

The Bank of Canada today increased its target for the overnight rate to 1 1/4 per cent. The Bank Rate is correspondingly 1 1/2 per cent and the deposit rate is 1 per cent. Recent data have been strong, inflation is close to target, and the economy is operating roughly at capacity. However, uncertainty surrounding the future of the North American Free Trade Agreement (NAFTA) is clouding the economic outlook.

The global economy continues to strengthen, with growth expected to average 3 1/2 per cent over the projection horizon. Growth in advanced economies is projected to be stronger than in the Bank’s October Monetary Policy Report (MPR). In particular, there are signs of increasing momentum in the US economy, which will be boosted further by recent tax changes. Global commodity prices are higher, although the benefits to Canada are being diluted by wider spreads between benchmark world and Canadian oil prices.

In Canada, real GDP growth is expected to slow to 2.2 per cent in 2018 and 1.6 per cent in 2019, following an estimated 3.0 per cent in 2017. Growth is expected to remain above potential through the first quarter of 2018 and then slow to a rate close to potential for the rest of the projection horizon.

Consumption and residential investment have been stronger than anticipated, reflecting strong employment growth. Business investment has been increasing at a solid pace, and investment intentions remain positive. Exports have been weaker than expected although, apart from cross-border shifts in automotive production, there have been positive signs in most other categories.

Looking forward, consumption and residential investment are expected to contribute less to growth, given higher interest rates and new mortgage guidelines, while business investment and exports are expected to contribute more. The Bank’s outlook takes into account a small benefit to Canada’s economy from stronger US demand arising from recent tax changes. However, as uncertainty about the future of NAFTA is weighing increasingly on the outlook, the Bank has incorporated into its projection additional negative judgement on business investment and trade.

The Bank continues to monitor the extent to which strong demand is boosting potential, creating room for more non-inflationary expansion. In this respect, capital investment, firm creation, labour force participation, and hours worked are all showing promising signs. Recent data show that labour market slack is being absorbed more quickly than anticipated. Wages have picked up but are rising by less than would be typical in the absence of labour market slack.

In this context, inflation is close to 2 per cent and core measures of inflation have edged up, consistent with diminishing slack in the economy. The Bank expects CPI inflation to fluctuate in the months ahead as various temporary factors (including gasoline and electricity prices) unwind. Looking through these temporary factors, inflation is expected to remain close to 2 per cent over the projection horizon.

While the economic outlook is expected to warrant higher interest rates over time, some continued monetary policy accommodation will likely be needed to keep the economy operating close to potential and inflation on target. Governing Council will remain cautious in considering future policy adjustments, guided by incoming data in assessing the economy’s sensitivity to interest rates, the evolution of economic capacity, and the dynamics of both wage growth and inflation.

The sixth round of NAFTA negotiations between Canada, the U.S. and Mexico get underway next week in Montreal. President Donald Trump has repeatedly threatened to withdraw.

Poloz said it’s very difficult to quantify NAFTA’s impact because it varies not only by sector, but also from firm to firm. “So we’ve chosen not to get buried in all of that,” he said. The immediate impact — already being felt — is a chill on business investment in Canada, as it’s either deferred or simply made in the U.S. instead. “That’s the sort of effect that could be bigger, in a binary sense, if an announcement is made that NAFTA is no longer to be. But again, even then, it would take time.”

The U.S. could also layer on additional trade actions that would worsen the blow, he said, citing ongoing actions in the aerospace and lumber sectors. “The analyses that you’re looking at do not consider the channel that I’m trying to emphasize the most,” he said, adding the shock of a NAFTA collapse is difficult to analyze. He contrasted it to the 2014 collapse in oil prices, whose effects were easier to predict.

“You will need the benefit of time and data to understand this as it all unfolds, and so markets should not think of it as a binary event, and I’m hopeful that they’ll appreciate the conversation we just had,” Poloz said.

There is a lot at stake if NAFTA dies for all countries involved but there is a lot of scaremongering going on too.

Importantly, the death of NAFTA, if it happens, doesn't mean the death of trade between Canada, the US and Mexico. It just means new tariffs and new rules and new bilateral trade talks for Canada and Mexico (with the US).

I say this because people are running around saying the Canadian dollar will plunge 20% if NAFTA dies and I would urge all hedge funds and large institutions to load up on the loonie and Canadian stocks and bonds if such an overreaction occurs (look at the British pound now relative to where it was right after Brexit vote).

The Bank of Canada decision hit the newswires at exactly 10 am ET but there was a big jump in USD/CAD beforehand.

It wasn't just a liquidity issue either, there was two way trade higher for at least 20 seconds before the announcement.

Now maybe that was some kind of engineered squeeze, because even if the hike leaked, you wouldn't be pounding the 'buy' button in USD/CAD. However, given all the news in the statement, buying was definitely the right short-term trade.

The Bank of Canada and StatsCan have had issues with data security in the past. I think it's time for another investigation.

For those of you who don't know how it works, reporters covering the decision are in lockup three hours prior to the release of the statement. I'm assuming they turn in their cell phones at the door but are allowed to visit the restroom if they need to.

It wouldn't be such a stretch of the imagination to assume someone leaked the news and what really irks me is it has happened before in Canada and the US. If authorities really wanted to properly investigate this, they can easily trace where the buy USD/CAD orders came from and get to the bottom of this "unusual trading activity" moments before the announcement (what a disgrace).

But currency markets still being the Wild West of trading, don't hold your breath on any investigation taking place.

[Note: Canada's big banks will find any excuse to raise the prime lending rate. If the Bank of Canada didn't raise, they would use the recent rise in US long bond yields as an excuse to raise the prime lending rate. Heads or tails, they win!!]

The important thing to remember is when the Canadian dollar gets hit, import prices go up, inflation pressures build. Conversely, when it appreciates, import prices decline, inflation pressures abate. This is especially true for a small open economy like Canada.

In financial terms, the financial conditions tighten when the Canadian dollar appreciates and loosen when it depreciates. What is important is to look at the trend over the last 18 months and take the average exchange rate over that time to see the effects on the real economy.

But it's also important to note if the Canadian dollar appreciates a lot going forward, it takes pressure off the Bank of Canada to raise rates. Still, typically currencies move ahead of a rate decision and once it is announced, they sell off if expectations were priced in for an increase.

This is why even though the Fed has signaled it's raising rates, and the market is pricing it in, the US dollar has weakened as the markets expect slower growth prospects in the US relative to the eurozone and Japan. Once their central banks start raising, the euro and yen will decline relative to the USD.

Looking at the weekly chart of the Canadian dollar ETF (FXC), you see seasonal yearend weakness was followed by an appreciation as oil prices moved up (click on image):

The loonie is at an interesting technical level and if global growth comes in stronger than expected, oil prices continue to rise, and NAFTA talks don't fall by the wayside, we might see an important breakout in Q1 and Q2.

This remains to be seen. On Friday, I will be discussing whether a mini global economic boom is underway and it's an important comment you don't want to miss.

You can download the report here and I guarantee you it will be an eye-opener. The National Bank's chief economist and strategist, Stéfane Marion, and senior economist, Matthieu Arseneau, put together a series of charts that explain why things aren't as bad as naysayers claim.

Below, a small sample of charts that caught my attention (click on images):

That last one really caught me off-guard. Again, take the time to download the entire special report which is available here. It's excellent and since I worked with Stéfane Marion in the past, I know he's a great economist who is careful with his analysis (there is no hyperbole here).

Still, I remain highly skeptical on Canada's debt profile and growth prospects going forward, and if we don't get more solid global growth over the coming year, it won't bode well for the Canadian economy and overindebted Canadians.

The National Bank piece begs a question: is debt to disposable income the only or most important ratio to consider in relation to the overall issue at hand?

Josh gestures at the above question when he points out in the podcast that over the last 15 years Canada has moved from being a resource economy to a FIRE economy, where real estate related activity has become a major driver of GDP.

If he is right about this, then perhaps debt to disposable income is a misleading ratio: debt increases as property prices increase and income increases due to high real estate activity, creating a virtuous cycle on the way up, and vicious one on the way down. If we are a FIRE economy, then perhaps saying everything is cool based on debt to disposable income is comparable to telling the employee with his life-savings invested in his employer’s stock that everything is cool based on the price of the stock alone.

To underscore the point that Canada has become a FIRE economy, he referred me to this Financial Post article which talks about Macquarie's research and states this:

About 30 per cent of nominal GDP growth has come from residential
investment and auto sales over the past three years. This is about 50
per cent greater than what has been experienced in similar prior
periods. The wealth effect from rising home prices has driven nearly 40
per cent of nominal growth in gross domestic product over the past three
years, about two to four times the amount experienced previously when
the BoC was hiking rates. Even as this has occurred, fixed business
investment and exports have struggled, limiting the ability for a
virtuous domestic growth cycle to unfold. This again is in sharp
contrast to similar periods in the past when these were accelerating.

Also, take the time to read Garth Turner's latest comment, What it means, where he states the following:

Only in Canada would a quarter-point rate increase grip the nation. It’s weird. The folks in Venezuela (inflation 2,350% this year) would laugh at us. Such first-world problems we have.

However, there’s a good reason this week’s news matters. Consider those lines of credit secured by real estate that people have binged on. We owe an historic $211 billion in HELOCS. Astonishingly (says the federal government) four in ten people are paying nothing on them. Nada. Ziltch. Another quarter pay just the interest. So, two-thirds of borrowers haven’t been reducing their debt load by a penny – even during a time when the cost of money’s been incredibly low. What a losing strategy. Everyone should have known rates would rise. Now they are.

Home equity lines float along with the prime. A quarter point increase means families will have to fund $1.6 billion more in bank charges in 2018, or try to absorb that amount of additional debt. That’s what a lousy quarter point means. When surveys show us almost half the households in Canada have less than $200 after paying the monthlies, how can this not matter?

Garth isn't making this stuff up, there are far too many Canadians who have been highly irresponsible with their home equity line of credit and if rates start rising, it will come back to haunt them.

But as I keep telling people (including Garth), stop only looking at rising rates, they are only part of the puzzle. You need to also look at employment because in a debt deflation economy, if there is a shock to the global economy and unemployment in Canada starts rising fast, it will be game over for the housing market and the economy for a very long time. At that point, record high debt levels will really hurt consumers and the economy.

I hope I'm wrong on the global economy but that is going to be a discussion for my subsequent comment on Friday. Stay tuned.

Below, take the time to listen to the press conference from Bank of Canada Governor Stephen S. Poloz and Senior Deputy Governor Carolyn A. Wilkins. I don't envy Steve and Carolyn's job, this is far from being an easy environment to conduct proper monetary policy.

Also, thake the time to listen to Erik Townsend and Josh Steiner discuss the global housing bubble on MacroVoices. Steiner thinks Canada's "Minsky Moment' has arrived and if he's right, it spells big trouble ahead for the Canadian economy an over-indebted Canadians. Steiner is even more bearish on Australia's housing market. See the accompanying slides here.

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